We covered a number of themes in this week’s conference call (playback details), but one that resonated the most was whether the developments in financial markets during the first half of this year could be viewed against similar historical experiences. In particular, with the Federal Reserve and Bank of Canada aggressively combating high inflation, would these attempts ultimately drag the North American economy into recession? The discussions since our call argue for a more detailed examination of past situations and how they might shed light on what we can expect going forward.

 

As we noted, the consensus probability of a recession taking place has increased over the past several weeks and the median estimate is somewhere between 60-70%. In other words, the call is better than a coin toss according to economists and market pundits; although there is no outright consensus forecast of a contraction in either the Canadian or US economy.  Just guesses.

 

The following chart is a little busy, so let me explain it.  Whenever you hear of how certain economic indicators are better or worse than expectations, what we are referring to is how these actual results compare with the average of forecasts made by economists and analysts. This average comes from a survey of forecasts done regularly by media outlets and other agencies. In fact, after a stint in the economics department at another bank, I worked for a company that was on the forefront of creating these surveys and providing real-time analysis of world events – MMS International. I provided forecasts to MMS before joining in 1991 and would later contribute forecasts to others after I left the firm and continued in my role of economist. But I digress.

 

 

The wonderful thing about high frequency forecast surveys is that we can see how economists are changing their views of many different indicators, like real gross domestic product (GDP) – the measure of economic output that we get quarterly. The chart shows how the estimates for a specific quarter change over time. In this case, I have gone back to the beginning of February and looked at consensus estimates for quarterly annualized growth for the fourth quarter of this year, plus the first three quarters of 2023.

 

In February, economists predicted that growth was going to diminish over the course of the next year, but the greatest variation in predictions has been in the views on economic activity at the end of this year and the first quarter of next year. Consensus forecasts for fourth quarter growth have fallen from 2.9% down to 1.5% as of this week. Estimates for the first quarter of next year have slumped from 3.1% to 2.3%. The biggest downward revision, however, is on the fourth quarter – and for good reason. Monetary policy tightening has gone into hyperdrive in the space of a few months. Logically, this has brought forward the timeframe for an economic slowdown. Yet, the consensus forecast doesn’t show one negative quarter. In fact, economists seem to be on the side of a soft landing.

 

That is where we took the conversation on the call. Let me start with the punchline. There are, in my opinion, only two key things to watch in the coming months – when do the Fed and Bank of Canada stop raising rates and how long do we wait before they start to cut rates? Inflation, last quarter’s earnings results, Ukraine, supply disruptions? They all matter, but ultimately feed into the answers to these two questions.

 

 

There are four policy meetings left for both the Bank of Canada and the Federal Reserve this year. Here at home, the Bank will deliberate on July 13^th, September 7^th, October 26^th and December 7^th. For the Fed, the meetings will be July 27^th, September 21^st, November 2^nd and December 14^th. Markets expect that the Bank will follow the Fed’s latest move of a 0.75% increase in rates. Both central banks have raised rates three times, but the Fed has overtaken the Bank at the end of the second half, with an overnight rate target of 1.75% versus 1.5% in Ottawa. Many economists believe the Bank will increase by 0.75% in July, but the same consensus stands behind the same hike by the Fed in the same month. There is always room for a surprise, but with inflation numbers unlikely to budge much before either meeting next month, the consensus call looks sound.

 

 

It is September and beyond where things get interesting, taking us back to the first question of where lies the last central bank hike, at least on a short-term basis. I have commented before that the speed of this tightening cycle is the fastest we have seen since 1994. It is interesting that this is also the first time the Fed has raised rates by three-quarters of a point since that year as well. This was no gentle period, as rates went from 3% to 6% in the space of a year. There were three half-point increases thrown in alongside that 0.75% jump. Still, we didn’t produce a recession. Why? Mainly because authorities saw that the economy was being impacted more than desired and rates were cut five months after the February 1995 hike to 6%.

 

From January 2015 to January 2019, the Fed raised rates from 0.25% to 2.5%. In August of 2019 rates went into reverse as the economy slowed in response to tighter financial conditions and a trade war between the US and other countries. Still, a recession was averted because of the quick about-face, and it took a pandemic to finally bring a halt to the economic cycle.

 

The opposite was true in 2000 and the lead-up to the financial crisis. In fact, I believe the similarities between now and 2000 are closer than any other recent tightening cycle. In 2000, the Fed began tightening in May – a month after the US leading indicator peaked. This year, we saw the Fed start hiking in March, just after the peak in the US leading indicator in February.

 

Some think that the recession that started in 2000 was created by the tech bubble implosion that year when, in fact, it stemmed from the decision to continue raising rates through the initial phase of the equity market correction. The next mistake was waiting almost 8 months before starting to cut rates. The result was a recession, compounded by the trauma of the 9/11 attacks, leading to a plunge in the Fed’s official target rate to below 2% by the end of 2001. The lack of agility would ultimately lead to a net decline in the S&P500 from 2000 to 2002 of approximately 50%.

 

The same mistake would then be made in 2006 when, after raising rates from 1% to 5.25% in the space of two years, the Fed waited 15 months before reacting to worsening conditions to start lowering rates. We all know what the outcome was, and it amazes me event today how there is still debate as to how the crisis was not a foregone conclusion.

 

 

The point here is not to infer that we are in for another 2000 experience or that this is going to be a repeat of 2008-09, unless we get into a situation where central bank tightening is continued well beyond this summer or if there is a prolonged delay between the last rate hike and the first rate cut. Based on market activity, it appears that most are unclear. That said, the pendulum does seem to be swinging from excessive confusion and fear towards a more rational environment.

 

Economic indicators are already showing signs of moderation, especially in housing and business sentiment.  Energy and material prices are in decline and that has intensified this month, despite continued talk of supply disruptions. Crude oil futures have fallen below $100/barrel and gasoline futures are off more than 10% from their peaks earlier this month. In other words, the disinflationary pattern is already underway. How quickly this translates into a significant decline in headline inflation is anyone’s guess; however, even at a 0.5% per month rise in the US consumer price index (CPI), inflation will settle in around 6.5% by the end of the year. Take that down to 0.2% per month, which would be consistent with previous economic slowdowns (not recessions) and inflation comes in closer to 5% by year-end.

 

It all comes back to how quickly the Fed and Bank of Canada switch gears. If both central banks move their target rates to 3% after their September meetings and hold, then we are halfway to achieving a soft landing. If both economies fall below their growth stall speeds in the second half and we see a shift in policy in January, then I think we can repeat the experiences witnessed post-1994 and post-2018. If rates move higher or if there is a longer pause, then the probability of a recession in 2023 increases past today’s assessment.

 

There has been a ton of criticism launched at both central banks since the pandemic, from relaxing inflation targeting paradigms (as with the Fed) to not acting swift enough to combat rising inflation. The latter is kind of pointless given that the same analysts that come out with these comments were themselves forecasting only a moderate policy response in 2022. We actually think there is an opportunity here for central banks to achieve both a stabilization in prices and an extension of the economic and credit cycle. The reason is that they are using the one thing that doesn’t get mentioned much and that is the secular rise in debt and the higher interest sensitivity the US and Canadian economies have because of it. For the rest of us, we are just going to be as data dependent as the central banks.

 

Playback details of this week's conference call can be found below:

 

Playback details:

Toll-free dial-in number: 1-800-408-3053

Local dial-in number: 905-694-9451

Passcode: 6307927#

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.